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It’s not been a good month for Class X Noteholders. Following the judgment in the Windermere VII case (see our commentary here) in which Snowden J found against the Class X Noteholder, the Chancellor of the High Court, Etherton J, in Titan Europe 2006-1 P.L.C. and others [2016] EWHC 969 (Ch) similarly rejected the arguments put forward by the Class X Noteholders.

The case concerned four transactions in the Titan series of CMBS transactions and in particular the interpretation of certain contractual provisions which impact the entitlement of the Class X Noteholder in those securitisations. The cases had originally been consolidated with separate proceedings in Titan Europe 2006-3 P.L.C. but those were ultimately settled prior to trial – see here.

In the remaining litigation the Court was asked to consider the following questions:

When calculating the Class X Interest Rate in accordance with the Conditions, is it necessary to take account of any additional interest due under the Loans following a default?

At what rate is interest to be paid on unpaid interest on the Class X Notes?

In circumstances where any of the Notes (excluding any Class X Notes) are outstanding following their Maturity Date and/or a Note Enforcement Notice has been served, are the Class X Notes to be immediately redeemed by the Issuer with the funds held in the Class X Accounts, or should the Class X Notes instead remain outstanding until all of the other Notes have been redeemed?

In the event that the Class X Notes are not immediately redeemed following their Maturity Date and/or a Note Enforcement Notice has been served and instead remain outstanding, how is the rate of interest that accrues in respect of the Class X Notes to be calculated?

The most significant of these was no doubt the first issue in which the claimants (who were holders of the Class X Notes) were contending that additional interest due under the Loans should be taken into account when calculating the interest due on the Class X Notes. As, broadly speaking, Class X Interest was calculated as the difference between interest due on the Loans over interest due on the Notes (plus certain transaction expenses), if accepted that would have meant the Class X Notes had been substantially underpaid on all four of the transactions in question. Issue 2 was therefore a consequential matter to be considered and issues 3 and 4 stemmed from the fact that 2 of the transactions had now reached maturity but the Class X Notes had not been redeemed. Needless to say, the Claimants argued that Class X Notes should not have been redeemed and were entitled to additional interest going forward.

The Judgment

Issue 1 – Default interest

The Chancellor concluded that “no account should be taken of additional interest following a default under the Loans”.

He came to this conclusion despite having accepted the Class X Noteholder’s arguments that “default interest” is “interest” and that “an interpretation of “Net Mortgage Rate” which excludes default interest allows for the possibility of an excess going to [the Issuer’s] shareholders and so to charity”. This was because there were a number of factors that “lead the informed reader to understand that, giving the words their natural and ordinary meaning, “per annum interest rate” was not intended to include default interest”. These include the fact that the default interest rates were not set out in the Offering Circulars (and investor had no access to the loan documents) and that each of the other elements (such as the interest rate of the Notes or the administrative expenses) used in the calculation of Class X interest were uncomplicated calculations. Having identified two competing interpretations, the Chancellor went on to consider which was most likely to carry the commercial intention of the parties. In coming to his conclusion, the Chancellor relied, amongst other things, on the following reasons:

It was counter-intuitive for Class X notes to be entitled to benefit from a worsening performance of the Loans;

There was no indication in the Offering Circulars that the Class X Notes would perform in this way in case of Loan default;

As the Class X Notes are paid the difference between what was due (but not necessarily actually paid) on the Loans over what was due on the Notes, there was an assumption that the Loans would perform according to their terms;

It was not envisaged that there would ever be such defaults in the Loans as would generate an excess over the specified margin between the basic annual interest rates payable on the Loans and the rates payable on the Notes;

While some defaults would have been expected, it was common ground that the defaults that occurred on the Loans were “outside the range of expectations” and hence there was little possibility “that such an extensive failure might be remedied in full, including the payment of default interest”;

Additional costs of recovering defaulted payments were not included in the calculation of Class X Interest and hence it would “be an extraordinary commercial intention for the Originator to take the benefit of additional payments referable to defaults under the Loans (resulting in the Class X Noteholder receiving a greater proportion of the Loan receipts relative to the Class A-H Noteholders) without bearing any of the cost of securing the making good of such defaults”; and

If default interest was included, it would make the calculation of the Class X Interest Rate quite complex, and it was questionable whether that had been the intention of parties given the short time frame between the payment of interest on the Loans and payment of interest on the Notes.

Issue 2 – Interest on unpaid Class X interest

This issue did not arise as the Chancellor decided that there was no unpaid Class X Interest and he resisted the temptation to provide obiter comments that might be referred to in other cases with different drafting. This was, of course, the opposite approach to that taken by Snowden J in the Windermere VII case. It is likely that the citation of that case in these proceedings contributed to the Chancellor adopting this approach.

Issue 3 – Redemption of Class X notes

The Chancellor ruled that the Class X Notes should be redeemed upon their Maturity Date and/or following the service of a Note Enforcement Notice as “there is no discernible business justification at all for not redeeming the Class X Notes at their Maturity Date”. Furthermore, it was noted that if the Claimant’s arguments were accepted, the “Class X Notes would remain in existence indefinitely with first claim on payments of arrears of interest from the borrowers, at a higher proportionate rate due to default interest under the Loans, and without bearing any of the additional cost consequences of recovering default payments and default interest, to the prejudice of Class A-H Noteholders who paid huge sums of money for their Notes and who alone bear the risk of default under the Loans. It is highly unlikely that the original parties to the structure ever intended such a remarkable situation”.

The Claimants had argued that the Class X Interest Rate should continue to be based on the pre-acceleration interest rates rather than the judgment rate of 8 per cent. as specified in the documentation. The Chancellor concluded that for the purposes of calculating interest on the Class X Notes following their Maturity Date and/or the delivery of a Note Enforcement Notice, the actual 8 per cent. interest accruing on the Class A-H Notes should be used. The Chancellor noted that the opposite argument that the original pre-enforcement and/or maturity rates of interest should continue to be used was “an impossible argument” noting that the Class X Noteholder’s own arguments on Issue 1 had made clear “that the Class X Notes are, in effect, entitled to any excess over the amount of interest due to the Class A-H Notes”. The judgment meant Class X interest would inevitably be reduced to zero past the maturity date of the Notes or the service of any Note Enforcement Notice.

Implications for the CMBS market

This judgment provides useful guidance not only on Class X notes but more broadly only interpretation of complex financial documents including the and importance of disclosure in offering circulars and prospectuses. However, given that the case relates to CMBS 1.0 notes which themselves provide for different mechanisms for the determination of Class X notes interest (as they do between these Titan series transactions and Windermere VII for example), the judgment is only directly applicable to transactions with the same Class X provisions meaning that further disputes in this area are more than possible. What is relatively clear is that the Courts appear to be taking a dim view on complex technical arguments that run counter-intuitively to the perceived commercial purposes of such securitisation transactions.